WPS5063
Policy Research Working Paper 5063
Background Paper to the 2010 World Development Report
Climate Change and the Economics
of Targeted Mitigation in Sectors
with Long-Lived Capital Stock
Zmarak Shalizi
Franck Lecocq
The World Bank
Development Economics
Office of the Senior Vice President and Chief Economist
September 2009
Policy Research Working Paper 5063
Abstract
Mitigation investments in long-lived capital stock to avoid getting locked into highly carbon-intensive
(LLKS) differ from other types of mitigation investments LLKS.
in that, once established, LLKS can lock-in a stream Even if the carbon markets were extended
of emissions for extended periods of time. Moreover, (geographically, sectorally, and over time), public
historical examples from industrial countries suggest intervention would still be required, for three main
that investments in LLKS projects or networks tend to reasons. First, to ensure that indirect and induced
be lumpy, and tend to generate significant indirect and emissions associated with LLKS are taken into account
induced emissions besides direct emissions. Looking in investor's financial cost-benefit analysis. Second, to
forward, urbanization and rapid economic growth suggest facilitate project or network financing to bridge the gap
that similar decisions about LLKS are being or will soon between carbon revenues that accrue over time as the
be made in many developing countries. project/network unfolds and the capital needed upfront
In their current form, carbon markets do not provide to finance lumpy investments. Third, to internalize other
correct incentives for mitigation investments in LLKS non-carbon externalities (e.g., local pollution) and/
because the constraint on carbon extends only to 2012, or to lift barriers (e.g., lack of capacity to handle new
and does not extend to many developing countries. technologies) that penalize the low-carbon alternatives
Targeted mitigation programs in regions and sectors in relative to the high-carbon ones.
which LLKS is being built at rapid rate are thus necessary
This paper--prepared as a background paper to the World Bank's World Development Report 2010: Development in a
Changing Climate--is a product of the Development Economics Vice Presidency. The views expressed in this paper are
those of the authors and do not reflect the views of the World Bank or its affiliated organizations. Policy Research Working
Papers are also posted on the Web at http://econ.worldbank.org. The authors may be contacted atzmarakshalizi@yahoo.
com and franck.lecocq@nancy-engref.inra.fr.
The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development
issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the
names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those
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Produced by the Research Support Team
Climate change and the economics of targeted mitigation in sectors
with long-lived capital stock
Background paper for the World Development Report 2010
30 March 2009
By Zmarak Shalizi and Franck Lecocq 1
Keywords: Climate change mitigation, capital stock turnover, carbon markets, mitigation
programs, lock-in
JEL Classification: Q54, Q58, H44, O22
1
Shalizi (zmarakshalizi@yahoo.com) is an independent scholar and former Senior Research Manager for
Infrastructure and Environment, World Bank. Lecocq (franck.lecocq@nancy-engref.inra.fr), the contact author, is an
Economist, with INRA and AgroParisTech, Engref UMR 356 Economie Forestière F-54000 Nancy. 14 rue Girardet,
CS-14216 F-54042 Nancy cedex, France. The authors thank Marianne Fay, Andreas Kopp, Philippe Ambrosi and
Jean-Charles Hourcade for useful comments on previous versions of this document. They also thank Jonathan
Pershing, Lee Schipper and Christophe de Gouvello for providing valuable data. The remaining errors are of course
entirely the authors'.
Climate change and the economics of targeted mitigation in sectors
with long-lived capital stock
Introduction
1. Two approaches to mitigation currently coexist. In the first, namely carbon markets, carbon
finance tends to flow, as one would expect, towards the regions and sectors where mitigation
costs are lowest. This is illustrated, for example, by the dominant share of HFC23 destruction
projects in the Clean Development Mechanism2 until 2006, and by the dominant share of non-
CO2 mitigation projects and of end-use industrial energy efficiency projects in 2007 (Capoor
and Ambrosi, 2008).3 In the second, the international community recognizes the need to
develop larger-scale targeted mitigation programs in regions and sectors in which long-lived
capital stock is being built at rapid rate to avoid getting locked into highly carbon-intensive
capital stock (e.g., the energy sectors in China or India). This is illustrated, for example, by
the new World Bank Climate Investment Funds, which explicitly target large-scale pilot and
scaling-up investments in sectors with long-lived capital stock, such as transportation,
building or power generation.
2. The objective of the paper is to clarify the economic rationale(s) for the two-tier
approach, particularly the need for the second approach, i.e., mitigation programs targeted to
long-lived capital stock, even though the focus of international negotiations post-Kyoto is on
expanding the first approach, i.e., the role of carbon markets to more countries and to another
commitment period. The argument is presented in three sections:
o In the first section, we note that long-lived capital stock investment and related
emissions have special characteristics that differentiate them from other types of
investment. Decisions made by rational agents (based on local technological options
and budget constraints) can lock-in energy/emission paths for long periods--as much
as a century or more. Casting a backward glance, we show--using a number of
historical examples from industrial countries--that, because of the lumpiness of
investments, the full capacity of long-lived capital stock (in the form of networks or
systems, and not just projects) is often installed in a relatively short period of time,
even though associated greenhouse gases (GHG) emissions and mitigation costs (high
or low) have long-lasting implications. This highlights the importance of limited
windows of opportunity to shift from high-carbon to low-carbon long-lived capital
stock where appropriate alternatives are or can be made available.
2
The Clean Development Mechanism (CDM) is a instrument under the Kyoto Protocol by which private or public
entities in countries with emissions targets under the Protocol (the so-called Annex B countries, i.e., developed
countries and economies in transition in Eastern Europe) can participate in the financing of projects that reduce
greenhouse gases emissions in a non-Annex B country (basically, developing countries) and get emission credits in
return. For more on the CDM, see Lecocq and Ambrosi (2007).
3
The unit costs of mitigating emissions of greenhouse gases other than carbon dioxide (CO2), such as methane (CH4)
or nitrous oxide (N2O), tend to be lower than the unit costs of mitigating CO2 because these molecules are more
potent greenhouse gases than CO2, and are valued accordingly under the Kyoto rules. For example, avoiding the
emissions of one metric ton of N2O is equivalent to avoiding the emissions of 310 metric tons of CO2, and thus
valued 310 times as much. Among non-CO2 gases, the unit costs of reducing HFC23 emissions are particularly low
because HFC23 is 11,700 times as potent as CO2 under the Kyoto metric, and because the technologies necessary to
burn this gas are cheap. Hence the popularity of HFC23 emissions destruction projects in the CDM.
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o In the second section, we cast a forward glance, and draw analogies to show--using a
number of current examples from developing countries--that with urbanization and
rapid economic growth important choices about the carbon intensity of future long-
lived capital stock are being made today (or will be made in the near future), and that
avoiding similar lock-ins in highly carbon-intensive pathways is important for global
climate mitigation.
o In the third section, we show that short `commitment periods' for carbon markets such
as in the Kyoto Protocol do not provide private or public agents with a price signal
that correctly reflects the special characteristics of long-lived capital stock, notably (i)
the long horizon of the direct emission streams of projects and networks, and (ii) the
stream of emissions indirectly resulting from or induced by investment decisions
regarding long-lived capital stock. In addition, neither the necessary price incentives
arising from the regulatory intent of carbon markets, nor the financing available from
such markets are likely to be sufficient to overcome financial and non-financial
barriers associated with low carbon technologies for long lived capital.
3. The importance of capital turnover for mitigation costs is not a new observation. In fact,
capital turnover has been a central issue in the debate on the optimal timing of climate
policies (see e.g., IPCC, 1996, chapter 9, and IPCC, 2001, chapter 8).4 On the one hand,
avoiding premature retirement of capital or costly retrofitting has been one of the arguments
in favor of delayed mitigation action (e.g., Wigley et al., 1996).5 On the other hand, the inertia
of the socio-economic system (of which capital stock duration is a component) and the inertia
of the climatic system can make it very costly to reduce GHG concentrations rapidly should
the ultimate damages of climate change prove to be high. It has thus been argued that when
inertia, uncertainty about damages and increasing information are correctly taken into
account, the optimal abatement path includes more mitigation in early periods than it would
were increased information not accounted for and uncertainty treated via certainty equivalents
(Ha-Duong et al., 1996, Ha-Duong, 1998).6 Going from one-sector to two-sector models (i.e.,
with long-lived capital stock distinguished from short-lived capital stock) leads to the same
conclusion, in particular that one should abate quickly in the most rigid sector because it is
where rapid efforts, if needed, will be the most costly down the road (Lecocq et al., 1998).
4. The analysis in the current paper is different from, and a complement to, this literature. First,
it intends to clarify the concept of `inertia'--typically modeled in a very crude way in the
above mentioned literature--by disentangling, with the help of some examples, the different
channels through which long-lived capital stock may lock-in emissions paths over the long
run. Second, and more importantly, it addresses a how to, and not a when question. By
discussing the specificities of investments in long-lived capital stock, it explores the extent to
which the presence of capital stock with a long life affects the choice of instruments to
implement mitigation objectives; and it provides some insights on how and where
governments might set up incentives for early action.
4
A debate particularly intense in the years leading to the signature of the Kyoto Protocol, and being revived now as
post-Kyoto targets are being negotiated.
5
Another key argument is that technological innovations will drive down the unit cost of carbon mitigating
technologies over time (partly because innovations, or even breakthroughs, will make carbon mitigating technologies
more efficient and effective--in terms of energy conversion--over time).
6
This is a quasi-option value argument (Arrow and Fisher, 1974, Henry, 1974, Hanemann, 1989)
3/39
Section 1. Choices about long-lived capital stock are usually made in short
periods of time, but have long-lasting implications for GHG emissions
5. Capital stock is not homogenous. In fact, long-lived capital stock is a composite of capital
stocks with different lifespans which can be disaggregated into the subgroups as follows:7
o Group 1 is capital stock with a lifetime of 5-15 years, which includes most types of
consumer durables (excluding short-lived consumer durables, such as personal
computers with 3-year life horizon, but including fridges, cars, etc. with 10+ year life
horizons). Investment decisions for group 1 capital stock are very decentralized (at the
level of households or individual units within firms), and the costs of energy services
plays a central role in the choice of equipment.
o Group 2 is capital stock with a 15 to 40-year time horizon, such as factories and power
plants. Decisions for group 2 capital stock are made for the most part by higher-level
entities, such as firms' headquarters or highest levels of governments. Except for
power generation capital per se, energy costs play a limited role in investment
decisions relative to other considerations such as e.g., strategic/competition criteria.
o Group 3 is infrastructure, with a 40 to 75+-year time horizon, such as road and rail
networks, power distribution networks, etc.8 As we will see below, such networks are
typically built-out in one to two decades and their size remains stable for decades with
only minor extensions. As in the case of group 2, group 3 decisions are mostly
centralized, and energy costs play a limited role. The initial projects in each network
increase the benefits of subsequent projects in the network.
o Group 4 is land use and urban form (land conversion and urban density) which can
persist beyond a century or more. This level is governed both by group 2 and 3
infrastructure decisions, and by policies that directly or indirectly influence urban
forms and land-use (e.g., tax policies, etc.). The conversion of land to urban uses is
generally unidirectional and irreversible. Early density patterns persist for decades or
longer (see also paragraph 44).
6. This note focuses on investments in capital stock with life duration in excess of 15
years--i.e., on capital stock in groups 2, 3 and 4 above--which have potentially significant
and long-lasting implications for greenhouse gases (GHG) emissions. In fact, the share of
emissions directly influenced by long-lived capital stock in total GHG emissions is
significant: roughly on the order of 41% of total World GHG emissions in 2000 (50%
when land-use change is excluded). This number is computed as follows. On the energy
supply side, the emissions from electricity and heat generation represent one quarter of total
World GHG emissions. These emissions are a function of the type of fuel used by the long-
lived capital stock (group 2 in the typology above), and would be different with a different
type of capital stock. On the energy demand side, direct emissions from the transportation
7
This division is based on the threefold categorization in Jaccard (1997) and Jaccard and Rivers (2007)--i.e.,
Group 1, Group 2+3, and Group 4. Here Jaccard's second group has been split into two to distinguish factories and
power plants (our Group 2) from infrastructure networks (our Group 3).
8
We have moved buildings from Jaccard's category 2 (our 3) to his category 3 (our 4), in light of Jaccard and Rivers
(2007) analysis suggesting their lifespan exceeds a century.
4/39
sector represent more than one tenth of total World GHG emissions. These emissions are
generated by relatively short-lived end-use equipment (group 1 above), but the demand for
transportation, and thus for energy, derives to a large extent from the complementary
transportation infrastructure that is in place, and from urban forms induced by it (groups 3
and 4 above). Similarly, direct emissions from the residential sector (which include energy
directly consumed by the residential sector for heating, cooking or heating--e.g., coal,
biomass, or gas--but excludes the emissions related to electricity or heat consumed by the
residential sector and produced off-site) account for more than one twentieth of total World
GHG emissions and originate from end-use equipment, but are driven in part by the energy
efficiency of buildings and thus by long-lived capital stock (group 3).9
7. A second key feature of long-lived capital--particularly the infrastructure component--is the
lumpiness of capacity installation--both at a plant or project level, as well as, at a network /
system level. At the level of an individual plant or project, it is well known that capacity
installation (entailing high upfront costs) will peak in a fraction of the time period the plant or
project will be functioning (plant life) before tapering off, even though output (in the form of
services generated by the capacity) and hence emissions associated with those services may
follow a smoother expansion path. It is the capacity installation process that locks-in the
subsequent emissions expansion path because once capacity is installed, high switching
costs10 determine the emissions path over the full life of the installation.11
8. More interestingly, the same dynamics is often encountered at network level (national scale)
which we show in this paper through examples with readily available public data. Aggregate
investments in networks of long-lived capital stock also tend to be concentrated in time (i.e.,
are `lumpy'). In other words, the capacity of these networks is put in place in relatively short
periods of time. Lumpiness might be related to, inter alia, economies of scale in technology
provision (as in the French nuclear case, where the program was cost-effective for
manufacturers only if a large enough number of plants were built, box 1), distributional
considerations (as in the case of the U.S. Interstate Highway, where federal resources might
have been more difficult to appropriate if the program had only targeted a few segments in a
few States, box 2), or historic and demographic shocks (as in the post-war housing
reconstruction in Europe, coupled with rapid population growth, see box 3). However, not all
investments in long-lived capital stock are lumpy at the national level (e.g., the French high-
speed train example in box 4 below). With readily available data we have not been able to
determine whether capacity expansion at the global level is lumpy or not. Our presumption is
that it is less so than at the national level.
9. Third, besides having potentially long-lasting implications for GHG emissions, and besides
the lumpiness of investment, systems built around long-lived capital stock also tend to
9
According to the World Resources Institute (2009), 2000 World GHG emissions are 33.2 GtCO2e (excluding
emissions from land-use change), of which the electricity & heat sector accounts for 10.3 GtCO2e (31.0%) and the
transportation sector for 4.8 GtCO2e (14.6%). Fossil-fuel emissions from the residential sector (excluding
consumption of energy from the electricity & heat sector) is estimated at 1.9 GtCO2e (5.6%) (IEA, 2002). The shares
of energy production, transportation, and residential use fall to 25.2%, 11.9%, and 4.6% respectively when emissions
from land-use change are accounted for.
10
In the form of expensive retrofitting or premature retirement.
11
Or at least until low-carbon alternatives to the complementary end-use technologies associated with the long-lived
infrastructure--e.g., cars for road infrastructure--are introduced, see paragraph 26.
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generate externalities, thus making it even more difficult to shift away at future points in
time. For example, investing in gas pipelines will make gas more competitive relative to
other fuels, thereby increasing demand and providing additional incentives for utilities, firms,
and households to invest in gas-fired heat and power generation capacity, thereby further
increasing demand, and generating further development in gas exploitation, extensions of the
gas network, and further reducing the relative price of gas--while at the same time limiting
resources available for investment in other types of energy, such as renewables. Cumulative
mechanisms such as increasing returns to scale (e.g., in the development of a dedicated
network branching off the main pipeline artery), induced technological change (e.g., in the
design of gas-fired appliances), learning by doing (e.g., creation of a specialized workforce),
or agglomeration economies (e.g., dependency on or clustering around the cheapest source of
fuel) might then make it more difficult to switch away from gas in the future.
10. The difficulty is that the entity that finances an individual project within a program or
network of long-lived capital stock does not necessarily include in its profitability/financial
cost-benefit analysis the effects of that particular project on the remainder of the
program/network via the above-mentioned externalities. Similarly, an entity that finances a
complete program or network of long-lived capital stock does not necessarily include in its
financial analysis the effects of that program/network on the remainder of the economy via
the above-mentioned externalities. Yet in both cases, the induced effects may have positive or
negative consequences socially. Where positive, such induced effects may justify, from
society's point of view, the implementation of the long-lived system, even if the net present
value is lower than other, shorter-lived options. But when negative, such induced effects may
create systems that outlive their usefulness by making it more difficult for other projects in
the future to adopt different technologies, thus creating path dependency or lock-ins.12
11. Though widely used in the economic and innovation literature, the term `lock-in' does not
have a unique definition, and it is used in various (if closely related) ways. In the presence of
`switching costs', decisions made at one point in time can partially or totally lock-in decision-
makers' subsequent choices--making it very costly to reverse ex post choices that were not
necessarily economically distinguishable ex ante (Farrell and Klemperer, 2007). One famous
example is the competition between technology standards, for example between the AZERTY
and the QWERTY keyboards, or between the VHS and BETAMAX video standards.13 In the
economic geography literature, positive feedback such as agglomeration economies can also
lock-in the growth / expansion path of locations / regions once initial choices are made (Fujita
et al., 1999). Here we use the term `lock-in' in an analogous way to designate cases in
which (i) the life duration of capital stock and the aforementioned cumulative
mechanisms generate a long-term stream of emissions, and (ii) high switching costs,
discourage later adoption of alternate paths with lower emissions.14
12
See also paragraph 74 and beyond.
13
Though the concept of increasing returns has a long tradition in economic history, the implications of increasing
returns and other cumulative mechanisms have been systematically explored only over the past three decades or so,
notably around issues of monopolistic competition (Dixit and Stiglitz, 1977), international trade (Krugman, 1979),
economic geography (Fujita et al., 1999), economic growth (Romer, 1990), or adoption of technologies (Arthur,
1983).
14
In standard cost-benefit analysis "sunk costs" (i.e., costs associated with past investments) are treated as irrelevant
to new investment decisions. This may seem to be at odds with the notion of lock-in discussed in this paper, which
suggests that extensions or subsequent steps are affected by initial investments or earlier steps. However, there is no
6/39
12. Positive feedback can generate `virtuous' or `vicious' cycles (World Bank, 2002). As such,
lock-ins are not good or bad per se. It depends on the objective pursued or consequences
generated. So is the potential for lock-in/path dependency a real problem vis-à-vis
climate change? This question has a two-fold response: an empirical one and a theoretical
one. The empirical answer is that because the share of long-lived capital stock in total
emissions is large (see paragraph 6), and because emissions path tends to be locked-in for
long periods of time once capacity is installed, inability to influence/re-orient the emissions
from this portion of total capital stock to meet an emissions target by a given date will
necessitate greater and possibly earlier effort on the remainder of the capital stock--
particularly if, with new information, the emissions reduction targets have to become deeper
than currently anticipated.15
13. The review of stabilization scenarios conducted in the IPCC Fourth Assessment Report
(Fisher et al., 2007, Table 3.5 and Figure 3.17) provides some basis for illustrative
calculations. Table 1 shows how much emission reductions would be necessary in the sectors
that do not involve long-lived capital stock for the World to be on a path (as per the IPCC) to
meet a given concentration target by a given date, provided no mitigation is undertaken in the
sectors that involve long-lived capital stock (here energy, transport, and housing).16 These
calculations suggest that a 450 CO2-eq concentration target would not be achievable this way
(because emission reductions would have to exceed 100% in the other sectors). Even meeting
a 550 CO2-eq stabilization target would require that nearly all emissions from the non-long-
lived capital stock sectors be abated.
real contradiction between the two. Even though previous investments (sunk costs) are not accounted for in
determining the cost-benefit ratio of the extension, the stream of future costs and benefits associated with the
extension may be different because of the earlier investments. That is, future costs and benefits may be different in
the presence of the earlier investments than they would have been in the absence of the earlier investments--as such,
the streams of costs and benefits are not independent. For example, if the backbone of a ring road or of a highway
network has been built, then building a new road to connect a suburb to that ring road or to that highway network (as
opposed to building a rail track) becomes much cheaper than it would have been had that initial investment in the
ring road or highway network not been made.
15
The IEA World Energy Outlook makes a similar point that "any delay in implementing emissions-reduction
policies will reduce the likelihood of the world achieving its climate-change goal. In the absence of incentives to
invest in low-carbon technologies over the 2012-2020 period, the CO2 mitigation potential in the power sector in
non-OECD countries would be reduced significantly, because less efficient solutions become locked in." (IEA, 2008,
p.493)
16
These calculations are based on the following conservative assumptions: (i) shares of electricity & heat,
transportation and housing sectors in emissions as described in paragraph 6, remain constant over time in the
business-as-usual scenario; (ii) capital stock in each sector is assumed to be evenly distributed across vintages, with
average lifetime of 100, 70 and 40 years in the housing, transportation and electricity & heat sectors respectively;
(iii) baseline emissions 50%, 80% and 100% higher than 2000 emissions in 2030, 2050 and 2100 respectively; (iv)
emission reductions in 2030, 2050 and 2100 to meet given GHG atmospheric concentration target as per Fisher et al.
(2007), Table 3.5 and Figure 3.17. Assuming that only half of the emissions from the electricity & heat,
transportation and housing sectors depend on long-lived capital stock does not fundamentally alter the results.
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Table 1. The required level of mitigation in non-long-lived-capital-stock-driven emissions to
be on a stabilization path in 2030, assuming no mitigation at all in long-lived capital stock
driven emissions
(in percent adjustment relative to the baseline)
Stabilization 2030 2050 2100
target
(CO2-eq)
445-490 >100% >100% >100%
535-590 73% 90% >100%
590-710 55% 44% >100%
Source: Authors' calculation
14. The theoretical answer is a bit more complicated. Since the issue of increasing returns and
path dependency started being discussed in the late 70s,17 a large literature has emerged
providing examples and debating the conditions under which path dependency is likely to be
observed. In this literature it has been argued that while increasing returns or positive
feedback (as is often observed in network externalities) can contribute to path dependency, it
is not a necessary condition, and that any type of negative externality can create path
dependency (Page 2006).18 More importantly, the presence of path dependency does not
necessarily mean that the path is economically inefficient. In a seminal work, Liebowitz and
Margolis (1995) distinguish three different types of path dependency:
o Type 1: Past decisions affect future decisions. This suggests an intertemporal
relationship19-- i.e., the path is sensitive to initial conditions. This is relatively
commonplace, and normal. This type of path dependency does not in itself suggest
any inefficiency problem. There can be multiple equilibria, e.g., driving on the right
hand or the left-hand of the road (Arthur, 1983), but no sub-optimality.
o Type 2: The chosen path proves to be inferior, but only ex-post (based on
counterfactuals or a change in circumstances). Since the regret factor emerges with
hindsight, it does not imply an inefficiency emerging from poor decisions, because it
could not have been avoided ex ante with available knowledge at the time the initial
decisions were made.
o Type 3: The chosen path can be demonstrated to be inferior and avoidable with
information available at the time the initial decisions were made. Liebowitz and
Margolis identify this last case as the one that does in fact imply an economic
efficiency cost to path dependency, but then go on to argue that the necessary
17
See footnote nb.13.
18
Four related (but separate) causes have been associated with path dependence-- increasing returns, self
reinforcement, positive feedbacks, and lock-in. "Increasing returns means that the more a choice is made or an action
is taken, the greater its benefits. Self reinforcement means that making a choice for taking inaction puts in place a set
of forces or complementary institutions that encourage that choice to be sustained. With positive feedbacks, an action
or choice creates positive externalities when that same choice is made by other people. Positive feedbacks create
something like increasing returns, but mathematically, they differ. Increasing returns can be tought of as benefits that
rise smoothly as more people make a particular choice [...] Finally, lock-in means that one choice or action becomes
better than any other one, because a sufficient number of people have already made that choice." (Page, 2006)
19
That is, the pair or sequence of events are not independent of each other.
8/39
conditions aren't often met in practice, and most decisions are rational at the time they
are taken. In other words, those arguing for inefficient path dependency need to
demonstrate why, with the information available at the time that the chosen path is
going to be suboptimal, that that path is nonetheless chosen over the superior
alternative.
15. Foray (1997) argues that the last condition is much too stringent. To generate this strong form
of inefficiency, he argues that "the system requires two classes of agents ­ some have the
right information to make the correct choice but fail to take advantage of the implied profit
opportunities, and agents who know nothing more than the payoff going to the next adopter."
In reality, however, there is often real uncertainty regarding the consequences of future
trajectories (that are resolved through experimentation and learning) at the time options are
selected. In addition, the selection of options may be based on local and not on global
optimization--in other words, the selection of options can be rational in terms of local
experience but not in terms of global experience. In fact, time and budget constraints may
favor a quick decision based on local experience, but not because it has been demonstrated to
be superior. Thus, choices do not have to be irrational at the time they are made to
generate inefficiency from an economic perspective. High switching costs can then lead
to the persistence of the selected option despite new information and options.
16. With regard to climate change mitigation, some lock-ins, such as structuring of energy supply
around coal or high carbon emission paths, are undesirable, while others, such as structuring
the economy around renewables or low carbon emission paths, are more desirable. The same
lock-in can in fact be both "good" and "bad" depending on the objective. For example,
reliance on abundant resources of domestic coal might be undesirable from a carbon
emissions perspectives, but be desirable with regard to energy security--which is why it is
important to weigh trade-offs not just in the short run but over the life of the lock-in. In the
following two boxes we give examples of a good and a bad lock-in. Box 1 illustrates the case
of a `good' lock-in from the perspective of carbon emissions, even though investment
decisions were not based on that objective. Box 2 illustrates how prior commitments to long-
lasting residential capital stock can generate a stream of carbon emissions and increase the
costs of abatement in the future.
9/39
Box 1. An unintended positive lock-in: The case of the French nuclear power program
17. One example of a "good" lock-in, from the climate change point of view, is the French nuclear
program, even though climate change mitigation was not an objective at the time the program
was passed.20 In 1974, after the first oil embargo, France embarked on a massive program to develop
nuclear energy capacity in the name of energy independence. The program (consisting of the
construction of a multitude of similar plants21 based on a single standard technology) was
implemented in a very short period of time (lumpy investment). In fact, half of the total program
capacity was online within a decade (i.e., by 1985), and nearly 80% by 1990.
18. Following the implementation of the program, the share of nuclear energy in total electricity
generation jumped from 16.5% in 1979 to 65% in 1990, and reached its plateau of around 77% in
1995. Between 1979 and 2007, overall electricity production in France grew 2.4-fold, from 241 to 540
TWh, but nuclear power production grew 11-fold, from 40 to 440 TWh. As a result, the production of
thermal electricity has been cut in half during this period. And as a consequence, overall CO2
emissions from energy generation have been cut in half since the early 1970s. CO2 emissions per
KWh of electricity and heat generated in France are now 1/5th of that in other large OECD countries,
such as Germany, the UK, or the U.S.22
19. From an industrial point of view, the cost-effectiveness of the program required that nuclear power
plants be built faster than expected demand, leading to excess supply. As a result, electricity exports
increased. In addition, the government pushed for the development of demand for electricity, notably
water heating and electrical heating both directly via incentives and indirectly via uniform pricing of
electricity across the country (including overseas departments), thereby de facto subsidizing electricity
generated from the grid relative to other energy sources. Between 1975 and 1988, the share of electric
heating in total domestic electricity demand increased from 26% to 44% (de Gouvello and Jannuzzi,
2002).
20. As of January 2009, about three quarters of the generation capacity was between 21 and 30 years old.
This points to the need for another round of lumpy new investment in power generation capacity
to compensate for the retirement of the current nuclear capital stock around 2020-2030
(depending on the effective average lifespan of nuclear reactors, currently estimated at around 40 to
45 years, even though extensions to 60 years are being discussed).
21. Looking forward, scenarios for electricity generation until 2050 (Charpin et al., 2000) suggest that for
a given energy demand scenario,23 cumulative CO2 emissions from electricity generation 2000-2050
will double if the nuclear capital stock is not renewed in the 2020-2030 period relative to scenarios in
which the nuclear capital stock is renewed. The difference is significant, on the order of magnitude of
3-5 years of (current) emissions of the country. Interestingly, extending the 30-year average design
horizon by 15 years, through modification of existing plants, will save as much in avoided emissions
as the difference between the with vs. without nuclear power scenarios.
20
This historical example aims to illustrate how investments in networks of long-lived capital stock can lock in a
country's emission path over a long period of time even though they unfold in a very short period of time. This
example does not discuss or evaluate the overall merits of nuclear power generation, neither historically for France,
nor in the future for France or for other countries.
21
Subtype 2 of long-lived capital stock noted in the decomposition above.
22
Data for Box 1 are from the French Ministry of Industry (http://www.industrie.gouv.fr/cgi-
bin/industrie/frame23e.pl?bandeau=/energie/statisti/be_stats.htm&gauche=/energie/statisti/me_stats.htm&droite=/en
ergie/statisti/se_stats6.htm)
23
And assuming significant but limited penetration of alternative renewable energy sources.
10/39
22. In Box 2 we discuss an example of long-lived capital stock of type 4, which is strongly
associated with the dynamics of urbanization. This dynamic can be graphed as a logistics
curve starting with a low proportion of total population living in urban areas, gradually
accelerating in response to rural to urban migration, and then decelerating, before stabilizing
with a high proportion of total population living in urban areas. Construction of physical
capital in response to this urbanization process creates a cumulatively larger stock of
buildings (residential, schools, civic buildings, offices, etc). The later energy efficiency
standards are adopted and implemented in this one-way process, the smaller the potential for
growing out of inefficient energy use later, as evidenced in the example below.
Box 2. Poor energy efficiency in long lived buildings increase future costs of abatement: The case of
the residential sector in France
23. The building sector in France provides a good example of how investment decisions over a
relatively short period of time can determine carbon emissions over long periods of time (up to
100 years)--especially when technical and economic costs of retrofitting or premature retirement
are high. In 2006 there were an estimated 25.7 million residential (habitation) units in France. The
vintages of this residential building stock can be roughly divided into three groups of approximately
equal size:
- one third (30.6%) built prior to 1949,
- one third built during the 25 year post-war reconstruction boom (1949-1975) prior to the
adoption and enforcement of any regulation on building energy efficiency, and
- one third built after 1975, under increasingly strict energy efficiency standards.
24. GHG emissions associated with the residential buildings include both direct on-site emissions from
e.g., home boilers or fireplaces, and indirect, off-site emissions associated with the production of the
power and heat consumed by (but not produced within) buildings. Direct emissions were 90 MtCO2 in
2002, and indirect emissions can be estimated at circa 12 MtCO2 (a small number due to the
predominance of nuclear power generation, and thus the low emissions per kWh in the country).
Overall, the residential building stock accounted for approximately 18.5% of France's GHG emissions
in 2002 (by vintage, the youngest third accounts for approximately 25 percent, while the oldest two
account for approximately 75 percent).24
25. Since the national share of the urban population has more or less stopped growing in France since the
1990s, the bulk of the housing stock in France is already built and the rate of annual additions is very
small. Because the average life duration of habitation units in France is well over a century, further
improvements in the efficiency standards for new building alone cannot prevent further growth in
energy consumption and emissions from the residential building stock over the next half century
(Traisnel, 2001). In fact, 60% of the expected residential building capital stock in 2050 has already
been built. To reduce emissions in this sector, accelerated retrofitting of old buildings (via e.g.,
improved window and wall insulation) and/or accelerated replacement of capital stock are necessary
to meet mid-century emission targets--even though both options will be costly, and are likely to be
costlier than having adopted and implemented higher energy standards 25 years earlier than they were.
This dilemma contrasts strongly with the `short window of opportunity' to grow out of inefficient
energy use described in the Chinese case (Box 6).25
24
Direct emissions from the residential sector are derived from IEA (2005). Indirect emissions are computed by
multiplying the share of residential consumption in total final consumption of electricity by total emissions from the
electricity & heat producing sector. Emissions by vintages are estimated based on data in Traisnel (2001) showing
that post-1975 buildings are on average 40% more energy-efficient than pre-1975 ones.
25
There is only limited scope for fuel-switching in domestic heating systems, as most coal-fired boilers have been
already been eliminated, and as liquid fuels represent only 20% of total energy consumption in the residential sector
11/39
26. It is important to note that the relationship between long-lived capital stock and
emissions differs between capital stock associated with energy provision (supply side)
and capital stock associated with energy use (demand side). On the energy supply side,
emissions are typically a direct function of the installed capital. Thus, the flow of
emissions associated with a particular stock of capital will generally last as long as the
underlying investment.26
27. On the energy demand side, on the other hand, the link between physical capital stock
and emission flows is generally less rigid. The relationship depends on the technology used
to supply the energy needed to meet the service demand induced by the long-lived capital
stock. In other words, demand side lock-ins can undermine the potential for energy
conservation, but not the use of any particular type of energy--low carbon or otherwise. If
energy were cheap (i.e., abundant relative to demand) and if harmful emissions were free
(both locally and globally), then there would not be any need for energy conservation / energy
efficiency (i.e., managing both final and intermediate demand). However, if energy is
expensive because of scarcity (or because the technology to avoid harmful emissions
increases the price), or if new technologies cannot generate energy without some harmful
emissions, then reducing the demand for energy becomes a necessary complementary pillar of
a low- or no-carbon energy strategy. In fact, according to the IEA (2006c), as much as two
thirds of emissions targets to 2030 will have to come from reducing energy demand, rather
than fuel switching in energy supply towards low carbon or zero carbon alternatives.
Similarly, the IPCC (2007, p.13) notes that "it is often more cost-effective to invest in end-
use energy efficiency improvement than in increasing energy supply to satisfy demand for
energy services."
28. The purpose of the next illustration is to highlight how demand-side infrastructure (e.g. a
highway network) can lock-in carbon emissions for the long-term (multi-decade), even
though partial decoupling can be achieved by changing emissions standards of
complementary physical capital (i.e., the fuel efficiency of the vehicle fleet).
as of 2003 (source: Ministry of Industry, http://www.industrie.gouv.fr/cgi-
bin/industrie/frame23e.pl?bandeau=/energie/statisti/be_stats.htm&gauche=/energie/statisti/me_stats.htm&droite=/en
ergie/statisti/se_stats6.htm). Entire conversion of domestic boilers from fuel oil to gas would save an estimated
maximum of 18 MtCO2e. And in fact this alternative is not available in most rural areas.
26
However, there are some cases where retrofit techniques (such as carbon capture and storage in the case of
production of energy from coal) can limit the emissions path ex post. In these cases, the life duration of the emissions
is not necessarily the same as the life duration of the underlying capital stock, even on the energy supply side. But
this is not a common feature of the relationship between emissions and the installed capital stock on the supply side.
12/39
Box 3. The complementarity of road infrastructure and the road vehicle fleet in generating energy
demand with its associated carbon emissions: The case of the US Interstate Highway System
29. The Interstate Highway System in the United States provides an example of a major demand-
side lock-in but with partial decoupling between capital stock and emissions. This example also
illustrates the concentration of investments in a short period and the shift in vehicle miles traveled and
energy consumption that it entailed.
30. The U.S. Interstate Highway System program, enacted in 1956, created a 42,700 mile network of high
quality highways linking major U.S. cities across the country. This massive undertaking was a lumpy
investment in a structural (not marginal) change in transport patterns. The network was built in a
relatively short period of time, with two thirds of it completed in less than two decades between
1965 and 1985 (Figure 1).
31. The interstate network represents only one percent of the total U.S. road network, but about one
quarter of the total U.S. national highway system. The interstate network also accounts for nearly a
quarter of total vehicle miles traveled (VMT) in the U.S. (24.4% in 2004), and nearly half of all heavy
truck traffic associated with interstate and global commerce. The networks share of total traffic grew
in proportion to the completion of the network: 10% of total VMT by 1966, 15% by 1971, and 20%
by 1982. For all practical purposes the network was completed by 1990 and its share of traffic has
remained more or less constant since then.
Figure 1. U.S. Interstate Highway System Mileage Increment over 5-year periods. 1950-2005.
U.S. Interstate Highway - Miles increment
over 5 year period
12000
10000
8000
6000
4000
2000
0
50
60
70
80
90
00
19
19
19
19
19
20
Source: Cox and Love (1996) for 1950 to 1965 data, and Weiss (2008) for 1970 to 2005 data
32. The rapid increase in the Interstate network's share of traffic can be explained in part by a shift in
vehicles away from older roads. More significantly, by reducing transportation costs, the Interstate
Highway System also made it possible for firms to both expand their reach and decentralize their
production over several sites, and to eventually reduce warehousing by adopting the Japanese
innovation in logistics of "just in time" delivery. We observe a doubling in the annual increment in
vehicle miles traveled after the mid-1960s (Figure 2) which can be attributed to additional demand for
transportation induced by the Interstate Highway System.27
27
We also observe that GDP and total VMT increase at nearly the same rate over the 1955-1965 period, but that total
VMT increase faster than GDP in the 1965-1973 period.
13/39
Figure 2. U.S. Vehicle miles traveled 1945-2000 (millions)
U.S. Vehicle miles travelled 1945-2000
(millions)
3,000,000
1945-1965
2,500,000 1966-2000
Linear projection of
2,000,000
1945-65 trend
1,500,000
1,000,000
500,000
0
1940 1950 1960 1970 1980 1990 2000 2010
Source: U.S. Federal Highway Administration
33. The Interstate Highway System also made it cheaper to develop land farther away from city centers,
thus playing a major role in an induced second "hump" in transport infrastructure investment and
energy use associated with accelerated suburbanization post-1990 (Figure 3).28
Figure 3. Total Highway Mileage in the U.S. 1960-2006
ay
Total Highw Mileage U.S. 1960-2006
4,100,000
4,000,000
3,900,000
3,800,000
3,700,000
3,600,000
3,500,000
1950 1960 1970 1980 1990 2000 2010
Source: U.S. Bureau of Transportation Statistics29
34. The conjunction of long-lived physical infrastructure, modified logistics patterns and resulting
systemic changes in the way businesses operate, and modified land-use in cities has led to a durable
28
In fact, the increase in urban highway mileage over the 1980 ­ 2006 period is higher than the increase in total
highway mileage because the mileage of rural roads has been decreasing over the same period.
29
A total of 43,000 miles of Bureau of Federal Land Management roads--excluded starting in 1998 from official
U.S. BTS statistics--have been reintegrated in this graph to avoid break in time series.
14/39
increase in total VMT. It has also contributed to the decline of the national railway network and made
it difficult when determining marginal extensions to meet growing transport demand to seriously
contemplate the introduction or restoration of alternate rail and transit links given the absence of a
larger supporting rail networks (as in Japan or Europe)--as opposed to adding more arterial roads.
This has reinforced the grip of the road network on meeting transport needs and generating carbon
emissions
35. CO2 emissions associated with the Interstate Highway System are significant, about 7% of total U.S.
emissions from fossil-fuel combustion.30 These emissions initially increased faster than the growth of
total VMT as the System developed. There was a temporary decoupling of emissions growth from
total VMT when higher energy efficiency standards were adopted in the mid-1970s (Figure 4).
36. However, emissions have resumed growing in tandem with total VMT in the absence of further higher
engine energy efficiency standards being adopted or enforced. Until more low-carbon or zero-carbon
vehicle engines are deployed, these emissions induced by the physical infrastructure network are to a
large degree locked-in.31
Figure 4. VMTs and estimated CO2 emissions from Interstate Highway Traffic 1958-2003
VMTs and CO2 emissions from U.S.
Interstate Highways 1958-2003
450 800000
400 700000
Highway emissions
CO2 emissions (MtCO2)
350 VMTs 600000
VMTs (billions)
300
500000
250
400000
200
300000
150
200000
100
50 100000
0 0
58
62
66
70
74
78
82
86
90
94
98
02
19
19
19
19
19
19
19
19
19
19
19
20
Source: U.S. Bureau of Transportation Statistics, Lee Schipper (comm.pers.), authors' calculation
30
Total emissions from the Interstate Highway System have been estimated by taking one quarter of total emissions
associated with road transportation in the U.S. (since the Interstate Highway System represents one fourth of total
VMT). This is likely to be an understatement as trucks represent a disproportionate share of travels on Interstates,
and emit more per VMT than cars.
31
Though Box 3 focuses on CO2 emissions, it should not be interpeted as downplaying the other externalities
associated with transportation. In fact, transport projects/networks should be designed to solve transportation
problems first. Conversely, solving the carbon externality may do nothing to solve these other externalities. For
example, congestion may still be a problem with zero-carbon cars.
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37. The U.S. Interstate Highway program was discussed for more than two decades before
actually being built. It does not appear that any clear alternative transport investment plan was
being discussed at the time. The options were to finance the new program, or to keep the
existing transportation network.32 From this one could conclude that there was no alternative
and an investment in the interstate highway system was unavoidable. To some extent, that
was true. However, roughly at the same time, high-speed train systems were designed in
Japan and, a decade later, in France (as discussed in the following box). At least at the global
level it is clear that alternative transportation technologies (with low carbon emissions) were
known at the time the U.S. Interstate Highway System was established. But, the alternative
was an imperfect one--it was costlier per unit mile of construction, it did not handle freight
transport, and it was not a dense network linking all the cities. Nonetheless, it was far more
efficient in terms of energy and emissions per passenger mile in the corridors in which it
operated, and there was nothing in the technology that precluded design of a denser network.
Box 4. Low carbon emissions in transport is linked to how electricity is generated: The case of
France's High-Speed Train Program
38. The French high-speed train program was initiated in the late 1960s by SNCF, the French public
enterprise which had monopoly over both rail infrastructure and rail transportation. The objective was
to limit train ridership erosion by competing more efficiently with cars and planes over major inter-
city corridors, not specifically to save energy or to limit greenhouse gases emissions. The first high-
speed train (TGV) prototype was natural-gas powered, but after the 1973 oil shock electrical engines
were adopted. This shift was a conscious decision to limit the energy cost of running the future train.
It is unclear whether it was made specifically to take advantage of the nuclear power generation
program that was launched in 1974 (see box n°1). (Again, even though at the time reducing emissions
was not a goal, the shift away from fossil fuel in the name of energy independence had the same
effect.)33
39. The first high-speed railway between Paris and Lyon was commissioned in 1974 and became
operational in 1981. Travel time between the two cities--400 km apart--was reduced from 4 to 2
hours, and travel time to cities further South along the same corridor was also reduced considerably.
Ex-ante and ex-post traffic surveys show that the modal share of rail increased considerably relative to
both roads and aviation in the corridors with high-speed rail. For example, the share of rail on the
Paris - SE corridor jumped from 44% to 61% from 1981 to 1984, while the share of road diminished
(from 46% to 30%) and the share of air also eroded slightly (from 10% to 8%) (OEST, 1986). The
surveys also point to a long-lasting overall increase in travel demand induced by the opening of the
new line along the corridor where the TGV is built (OEST, 1986, 1987). As new high-speed railways
were built, similar effects have been observed for inter-city trips up to 800 km. For example, it is
32
See the extensive discussion of the origins of the U.S. Highway System by Lee Mertz
(http://www.fhwa.dot.gov/infrastructure/origin.htm).
33
High speeds (i.e., over 220 km/h) can be achieved only on special railtracks with, inter alia, higher curvature
radiuses than regular railtracks, larger mid-track intervals, adapted bridges and tunnels, etc. Since the speed of all
trains on a given railtrack cannot exceed the speed of the slowest train, high-speed railtracks are TGVs-only (in
addition, slower trains are not adapted to certain physical characteristics of high-speed railtracks such as steep
ramps). TGVs, on the other hand, can run on regular railtrack (albeit at lower speed), thus making high-speed
railtracks an extension of the existing railtway network, and not an entirely new network. (This is no longer the case
when high speed is achieved through different technologies, such as magnetic levitation.) The higher design
standards are similar to the Interstate highway systems which are very different from regular highways. To support
high speeds `on and off ramps' have to have higher curvature radii, traffic in different directions have to be separated
from each other, entrances and exits from the traffic stream are spaced much further apart, etc.
16/39
estimated that air traffic from Paris to Marseille (750 km apart) was cut by a quarter due to modal shift
to TGV from 2001 to 2003.
40. This shift is important because average CO2 emissions per passenger.km are significantly lower for
train trips, because of the low emissions intensity of the French electricity system:34
15 gCO2/passenger.km against 111 for cars and 169 for planes (Raux et al., 2005). Overall, however,
the share of rail in total passenger transportation has continued to decrease since 1981 (though rail
ridership has increased) relative to road and to a lesser degree air (because the high-speed rail network
is not as extensive as the corresponding road and air network, it is important only in selected
corridors). Emissions have clearly been reduced relative to what would have happened had modal
shares remained as they were pre-TGV along the corridors where TGV was built. However, the TGV
program alone (at least as it stands now) has not been able to reverse overall trends in modal share
evolution.
41. Unlike the Interstate Highway Program which was meant as a network from the start, the high-speed
lines have been designed corridor by corridor. As such, the implementation of the program was not
lumpy. The first line was approved in 1974, the second in 1981, and the third and fourth in 1988 and
1989 respectively (but this may be due to the particular geometry of the country in which all lines
radiate out from Paris). However, the proposed extensions of the network (+ 2000 km, or doubling, by
2020) are expected to be lumpy investments. High speed train programs elsewhere in Europe are also
being conceived as networks from the beginning rather than corridor by corridor extensions (notably
in Spain, which plans to build over 7,000 km of high-speed railtracks criss-crossing the country).
42. Finally, it is important to note that the average cost of new high-speed railtracks in France is estimated
to be around 1.5-2.0 b/100 km, or about four times as high as the upfront costs of new 2x2 highways
(0.4-0.8 b/100 km). The difference in upfront cost is significant. The current market price of carbon
may not be sufficient to compensate for the difference.35 In other words, high-speed rail is not a
complete substitute for interstate highways, but rather a complement in high-density corridors. The
extra cost may not be justifiable on carbon grounds alone. But other related objectives, such as
reducing local air pollution or congestion related to cars may provide additional rationale for railway
development.
34
Had France the same CO2 emissions per kWh as the U.S., and everything else equal, rail emissions per
passenger.km would be around 100 gCO2.
35
For example, a 1000 km addition to the national network would cost about 10 b more with high-speed rail than
with highways. At a 10/tCO2 price of carbon, the high-speed train program would need to generate 1 btCO2e
emissions savings to justify the extra-cost solely on climate change ground. Since the emissions difference is about
100 gCO2 per passenger.km between rail and road, the rail program would need to shift at least 10,000 billion
passenger.km from road to rail over its lifetime to produce 1 btCO2e of emissions savings. Yet total road traffic is
currently 560 billion passenger.km in France against 80 for rail. So even if half the road traffic were somehow
shifted to rail, it would take at least 40 years for sufficient emission reductions to be generated.
17/39
Section 2. There is ample evidence that important choices about the carbon
intensity of future long-lived capital stock are being made today or will be made in
the near future, particularly in developing countries; and that avoiding similar
demand-side or supply-side lock-ins in highly carbon-intensive pathways is
important for global climate mitigation
43. Economic growth--spurred on by urbanization and globalization--is inducing rapid
expansion of long-lived capital stock in developing countries, similar to the development
of long-lived capital stock in Western Europe or in Japan post-World War II.
44. First, urbanization (i.e., an increase in the share of urban population in total population) will
be accompanied by major decisions about urban forms (category 4 of long-lived capital),
which will influence the energy system. In fact, as noted by Jaccard and Rivers (2007),
density configurations and land-use patterns affect the energy intensity of various end uses
(e.g., ratios of external wall to floor space for space heating), the energy requirements for
urban transportation (e.g., travel distances for shopping and commuting), and the character
and prospects for alternative energy supply and delivery systems (solar access, combined heat
and power, public transit, hydrogen refueling networks, etc.). This component of long-lived
capital stock has been estimated to have a 120 year turnover rate based on Canadian data. We
are not aware of any comparable estimates for developing countries (or even other industrial
countries).
45. More than 80% of the people on Earth live in developing countries. The bulk live in countries
that are predominantly rural. The sectoral shift from a primarily agricultural-based economy
to one based on manufacturing and services will be accompanied by a shift in the spatial
location of the population, i.e., urbanization. Approximately one third of developing countries
population lived in cities in 1990, whereas two thirds of that population is expected to live in
cities by 2050. In China alone, it is estimated that the share of urban residents in the total
population will increase by 50% over the next 25 years, from 40% in 2005 to about 60% in
2030.36 This will generate a lot of construction in a relatively short period as discussed in
box 5, with potentially significant consequences for emissions.
36
Source: Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat,
World Population Prospects: The 2006 Revision and World Urbanization Prospects: The 2007 Revision,
http://esa.un.org/unup .
18/39
Box 5. An important demand-side lock-in for the future arising from the major expansion of the
building stock: The case of China
46. Rapid urbanization and economic growth in China is generating a boom in construction--
comparable to post-War reconstruction efforts in Western Europe. Yet space heating in buildings
in China is inefficient: it consumes 50-100% more energy than in Western Europe or in North
America. The Chinese Government has promulgated new energy efficiency standards for
buildings, but the standards are often not enforced. Almost all of the new buildings being
constructed are still based on old, highly energy-inefficient designs (World Bank, 2001).
47. Emission-wise, China's space heating alone consumes on the order of 130 million tons of standard
coal equivalent per year, more coal than the unified Germany consumes for all purposes (in
energy terms). Total direct (on-site) and indirect (off-site) emissions from residential buildings in
China are on the order of 500 MtCO2 per year in 2003, the equivalent of total annual GHG
emissions from France.37
48. Enforcing standards in China for new buildings now can still have a significant impact on the rate
at which total emissions grow in the near future. Half of China's urban residential and commercial
building stock in 2015 will be constructed after the year 2000 (this contrasts with the fact noted
above that 60% of the expected building stock in France in 2050 will be buildings already built
before 2000). In other words, in China, unlike Europe and Japan where postwar reconstruction is
over and costly retrofitting maybe necessary, there is still an opportunity to "grow out" of the
enormous energy waste problem at relatively low cost.
49. Data remains scarce, but a rule of thumb estimate is that with existing technologies, Chinese
buildings can be made more energy-efficient, saving over 50% on energy costs with increases in
construction costs of some 10% (World Bank, 2001). Applied broadly, such a program would
have national implications for energy dependency, and could reduce a large amount of GHG
emissions--with global implications for climate change. However, energy expenditures savings
alone may not be sufficient to compensate for increased upfront building cost.38 Putting a price on
carbon (via e.g., a market or a tax) would help, but it is unclear whether it would be sufficient to
tilt the result of the financial cost-benefit analysis towards energy efficient buildings. In addition,
it is recognized that the development of energy efficient buildings in China face many other
barriers, related inter alia to information asymmetry or institutional design (Richerzhagen et al.,
2008). Yet if, on the other hand, actions are not taken now, every year lost in developing more
efficient buildings will lock-in some 700-800 million square meters of urban residential and
commercial building floor area with inefficient energy use for future decades. This could generate
more than two billion tCO2e of additional carbon by 2030 relative to an efficient energy use
scenario for residential and commercial buildings.39
37
Direct emissions from the residential sector in 2003 are based on IEA (2003). Share of residential sector in
electricity & heat generation are estimated using China 2003 energy balances (IEA, 2006a). In addition, the
residential sector in China consumes 217 Mtep of biomass. We did not find data on the associated emissions, but if
emissions/consumption ratios observed in the OECD are of any guide in the China context, the emissions from
biomass use might be larger than the emissions from all other energy uses in residential buildings combined.
38
In fact, indicative data provided in World Bank (2001) suggest that it may not be the case.
39
This figure is estimated by assuming that an average of 750 Mm2 of new building is built from 2004 to 2030,
either at 2003 emissions per square meter (of about 0.016 tCO2e/m2), or at half that rate (if new buildings are more
energy efficient).
19/39
50. Second, as a result of the globalization of the world's economy, many developing countries
are under pressure to engage in international trade more actively, and to become more
competitive. This is putting a premium on investing in category 3 type long-lived capital in
the form of infrastructure (transportation, power, and telecom) networks, whether provided
publicly or privately.
51. China's transportation sector provides an example of investment in long-lived capital
stock induced primarily by concerns about competitiveness and trade. As of 2004, China
had about 34,000 km of expressways, out of a total of 1.87 million km of roads. The first
segments were opened in 1988, and the bulk of the 2004 network (90%) was opened in the
previous nine years (1996-2004).40 In 2004, the country approved the National Expressway
Network Plan to connect all capitals of provinces and autonomous regions with Beijing and
with each other, linking major cities and important counties. The new expressway network is
explicitly designed to reduce transportation costs from the interior to the coast, and thus to
foster domestic trade and economic development inland. The network is expected to add an
additional 85,000 km to the current expressway network. The project is expected to be
undertaken over a 30 year period, with the bulk of the investment made in the first two
decades. This is another potentially important demand-side lock-in, akin to the example of the
U.S. interstate highway system discussed earlier, which is likely to generate additional
indirect (cf., box 4, Figure 2) and induced emissions (box 4, Figure 3).
52. The two examples above are both demand-side examples, but major lumpy investments in
supply-side long-lived capital stock are also expected. In fact, the IEA (2003) estimates
that 6 trillion U.S. dollars investment in energy supply is required in developing countries
until 2030, two thirds of which would be for power generation alone. Box No.6 provides one
example of major lumpy investments on the supply side that may generate lock-ins.
Box 6. A potential supply-side lock-in: The case of coal-fired power plants in China
53. With rapid economic growth, electricity demand in China has skyrocketed over the past two
decades. New power plants are being built at rapid pace to keep up. Total power generation capacity
in 2006 was 623 GW. This is twice the capacity of year 2000 and more than four times the capacity of
year 1990. As coal is plentiful and cheap in China, it accounts for about 75% of power generation
capacity. Because coal-fired power generation has higher GHG emissions per KWh than other power
generation technologies and because average efficiency of coal-fired power plants in China (33%) is
lower than in the U.S. (37%), Western Europe (39%) or Japan (42%) (Zhao and Gallagher, 2007),
CO2 emissions per KWh in China are about one third higher than in the U.S.,41 and about twice as
high as in Europe. With 1.8 GtCO2 (2003)--of which coal accounts for 97%--the power & heat
generation sector represents about half of China's total CO2 emissions, and as much as the CO2
emissions of Africa and the Middle East combined. Coal-fired power generation also has severe
consequences for local air pollution.
40
Source: China Statistics 2005, available at
http://www.allcountries.org/china_statistics/16_4_length_of_transportation_routes.html.
41
China's current higher emissions per KWh must, nonetheless, be viewed in the context of its overall declining
energy intensity over time. As a result of using more efficient technologies, combined with its faster GDP growth,
energy intensity in China declined by an extraordinary 4.8 percent per annum in the 23 year period from 1980 to
2003--more than double the 2 percent per annum decline in the US. As a result, China's energy intensity dropped by
half relative to the U.S. This significant pattern of change over more than two decades is the same whether one uses
GDP at market prices or purchasing power parity prices (Shalizi, 2006).
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54. Looking forward, the IEA (2003) estimates that power generation capacity in China will have to
more than triple between 2002 and 2030 to keep up with demand. There is thus a priori a
possibility for China to at least partly grow out of its current high-emissions power generation system,
since some half to two-thirds of the emissions of the power sector in 2030 depend on the additional
power generation capacity that will be installed between now and then. How this additional capacity is
balanced between coal, gas, nuclear, hydro and other renewables will be a prime factor in determining
those emissions. But the choice of technology within each primary fuel will also make a difference.
55. China is rapidly becoming a major player in non fossil-fuel energy.42 Yet because coal resources are
extremely abundant, and because the country is essentially devoid of natural gas, coal has so far
remained the cornerstone of the new power generation and is likely to continue playing an important
part in future capacity as well.43 The choice of technology for coal-fired power generation will thus
play an important role. China is installing some of the most sophisticated clean coal technology
(supercritical, ultra supercritical, integrated gasification combined cycle, etc.). However, since energy
demand is so large, many traditional dirty coal plants are also being built. Overall, until recently, the
average emissions per unit of electricity generation of the new coal-fired power plants were higher in
China than in the U.S.44
56. Recent modeling of the evolution of China's power sector (Wang and Nakata, 2009) provides
some economic insights on how the fuel mix, and resulting emissions, might evolve in the coming
decades. In their business-as-usual scenario, without any policy to internalize carbon or local
pollution externalities, the share of coal in power generation remains as high in 2030 as it is today, and
coal generation efficiency improves relatively little--thus resulting in a tripling of the CO2 emissions
of the power sector in 2030 relative to 2005. In an alternative scenario, introducing a carbon tax of
$120/tCO2 (about 6 times the current price on the carbon market) reduces electricity generation in
2030 by about 15% relative to the business-as-usual scenario; it reduces the share of coal in the power
generation mix from about 75% to about 50%; and it facilitates the penetration of advanced clean coal
technologies. In this scenario, CO2 emissions in 2030 will be about one third lower than in the
business-as-usual case. According to Wang and Nakata's analysis, there is real potential to
reduce China's emissions from the power sector by 2030 despite the cheapness and abundance
of coal--one-third of business-as-usual emissions in 2030, i.e., as much as today's (2005) emissions.
The question is how easy it will be to shift course
57. This study does not take into account the cumulative mechanisms that may make it more
difficult to reduce the share of coal and/or increase the share of advanced clean coal within total
coal-fired power generation. Besides the sheer lifespan of coal-fired power plants, cumulative
mechanisms such as increasing returns to scale (e.g., in the development of sector specific
transportation networks), induced technological change (that may make future coal technologies
cheaper rather than cleaner), learning by doing (e.g., on training of a specialized workforce), or
agglomeration economies (encouraging clustering and dependency on cheapest source of fuel) can
generate an undesirable lock-in to inefficient energy paths.
58. In addition, investment in renewables and clean coal face important barriers. Wang and Nakata
include one of these barriers, namely the fact that local air pollution is not internalized. But taking into
42
For example, China is already the largest producer of hydropower in the World (IEA, 2007), it is the second
largest market for new wind capacity behind the U.S. (World Wind Energy Association, 2009), and it has embarked
on a large-scale nuclear power generation program to increase generation capacity from 10 GW to about 70 GW in
2020 (Machenaud, 2009).
43
In fact, the share of coal in total power generation capacity has remained very stable over the past two decades,
which means that the additional capacity over the period has relied as much as coal as the initial capital stock.
44
Estimated by comparing the ratios between the additional emissions from the combustion of coal in the electricity
& heat sector between 1998 and 2003 (IEA, 2005) and the additional electricity production between 1998 and 2003
(IEA, 2006a, b) in the U.S. and in China. We do not have data for additional capacity installed post-2003.
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account others may also alter the picture. For example, developing countries often don't have the
necessary access to cutting edge technology to avoid the high GHG emissions associated with the
normal development of coal. Where the problem is a financing and/or technology sharing or
technology transfer one, one will need to design and adopt a targeted mitigation program (bilateral or
multilateral) to link buyers and sellers of the relevant technologies.
59. Until then, the adoption of dirty coal technology in coal abundant developing countries meets not just
Foray's observations about rational inefficiency, but even the more stringent criteria of economically
inefficient path dependency enunciated by Liebowitz and Margolis. Dirty coal investments may
generate lock-ins that are known to be sub-optimal ex ante from a global perspective--carbon
generated anywhere on earth has the same negative global consequence. However, with strong budget
constraints, and the lack of technology transfer agreements, a developing country's decision to adopt
the inferior technology can be locally rational ex ante--even though it leads to inefficient long-term
emissions paths.
60. Though both the demand-side and supply-side lock-in examples above are from China, they
are not unique. India is another large rapidly growing developing country with abundant coal
reserves to power cheap, but high carbon emissions electricity production. It has also initiated
a major interstate highway / road transportation infrastructure program, and is experiencing a
major expansion of its housing stock associated with urbanization. Similar investments in
long-lived capital stock with potentially large impact on GHG emissions can be observed
or foreseen in many other developing countries as well.
61. The current energy inefficient and emissions intensive long-lived capital (e.g.
infrastructure) expansion programs need not be treated as unavoidable. In many cases,
infrastructure networks providing similar services can be built using different technologies,
some with high carbon intensity, and others with lower or even zero carbon intensity. For
example, there exist coal-fired power plant technologies in China and elsewhere that are more
efficient than those typically used in China (e.g., Zhao and Gallagher, 2007). Similarly,
energy efficient buildings have been designed with better standards than existing ones (World
Bank, 2001). Similarly, a more balanced road + rail networks can be an alternative to a road-
dominated system. There are many reasons why low carbon alternatives are not currently
pursued. These alternative investment opportunities may be more expensive than the
currently used ones. They may not be secure strategically (e.g., alternative energy sources
may be less reliable because they are located abroad), or they may not be directly available to
local decision-makers because of barriers such as, the absence of technology transfer
arrangements, adequate human capital capacity, etc. Addressing all of these different barriers
will take time, especially in developing countries with limited institutional capacity.
62. However, as we have tried to note in this paper, the opportunities to shift from high- to
low-carbon intensity long-lived capital stock, are not evenly distributed over time. In fact,
the windows of opportunities may well be very narrow because these investments are
lumpy and concentrated in time.45 Installation of capacity for long-lived capital follows a
logistics curve. Changing an emissions path at the early stages will be a function of the
availability of alternate networks with lower emissions and of the cost-effectiveness of
shifting to those networks. For example, building urban infrastructure from scratch (or
rebuilding it after a war)--or establishing a road or rail network--will result in a large lumpy
45
Often these investments entail structural changes rather than marginal ones. Some will be based on centralized
economy-wide decisions and others on decentralized project by project decisions.
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capital investment in a short period of time. After that capacity expansion will decelerate (or
cease once the network is completed). Thereafter the scope for shifting the emissions path
through new investments will be low as new investments in that category of capital stock will
be marginal at best (plus maintenance costs). Once one is well along the logistics curve
switching costs make it difficult to shift to an alternative without incurring substantial costs of
retrofitting or premature retirement of otherwise functional capital stock.
63. As discussed in Section 1, emissions associated with long-lived capital stock are large
and, if mitigation is not undertaken early in those sectors, even deep and early
adjustments in the remaining (relatively short-lived) segments of capital stock may be
insufficient to meet stringent concentration targets. In addition, we have seen in Section 1
that uncertainty about long-term emissions goals (or about climate change damages)
tends to put an additional premium on acting early in sectors with long-lived capital
stock. Thus, if there is a peaking of infrastructure investment in the next 2-3 decades (as
China, India, and some other developing countries urbanize and rapidly build out their
multiple infrastructure networks), there will be a premium on earlier action rather than
later action on climate change in these countries because the impact on cumulative emissions
will be higher.46 If the necessary action is not undertaken, the ability to catch-up with target
emission goals later via the fraction of capital stock that are short-lived will be weaker, and
possibly insufficient. The next Section examines whether carbon markets alone can provide
appropriate incentives to influence investments in long-lived capital stock.
46
It is an irony that delaying imposition of carbon commitments on developing countries till their per capita income
is higher (a very laudable objective) runs the risk of missing the windows of opportunity to influence the carbon
efficiency of long-lived capital stock to be built in the next 2 to 3 decades as part of urbanization and globalization
associated with the process of development. This is one reason why climate change negotiations cannot be separated
from development objectives. In principle, CDM type programs can help, but their current scale is woefully
inadequate. Hence, scaling up targeted mitigation programs will be critical.
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Section 3. Carbon markets do not necessarily provide economic agents with
correct signals to make the decisions vis-à-vis long-lived capital stock
64. The previous discussion has established the importance of the magnitude of long-lived capital
stock, such as networks and urban forms, and of the lumpiness of investments in time. It has
also demonstrated how such capital stock investments can lock-in the generation of a stream
of carbon emissions that lasts a century or more in some cases.
65. On the basis of this information, the present section returns to the central question of the
paper, i.e., whether a two-tier strategy--carbon market plus targeted mitigation towards
sectors with long-lived capital stock--is economically justified or not. Specifically, we use a
reductio ad absurdum type of reasoning, and ask whether a one-tier, carbon-market-only
strategy could be sufficient to provide proper incentives for investments in long-lived
capital stock. To provide proper incentives to investments in long-lived capital stock, this
strategy would need to meet four conditions.
o First, the price of carbon generated by the market would need to be a correct
reflection of the shadow price of carbon. The relationship between market and shadow
price of carbon has many dimensions, most of which are general and not specific to
long-lived capital stock. For our purpose, the most important dimension is the
compatibility of the time duration of the long-lived capital stock, and the time horizon
of the carbon constraint.
o Second, as discussed in the two previous sections, investments in long-lived capital
stock projects or networks not only generate direct, long-lived, emissions, but also
indirect and induced emissions, which can be significant. Erroneous decisions can be
made if those are not taken into account. Thus, the carbon-market-only strategy
would need to provide a price signal relative to indirect and induced emissions,
and not just to direct emissions from projects/networks involving long-lived capital
stock, at the level of individual project or network developers.
o Third, carbon markets would have to provide sufficient additional financing for
lumpy investments. This is particularly important since networks of long-lived
capital stock tend to be established in short periods of time.
o Finally, even if the previous three conditions are met, the carbon-market-only strategy
would still need to occur in a context where investments in low-emissions long-lived
capital stock can compete on a level-playing field with investments in high-
emissions long-lived capital stock -- and this is not a trivial concern given the
presence of many unpriced externalities and transaction costs that implicitly favor
high emissions, long-lived capital stock.
66. In the remainder of this section, these four conditions are discussed in turn. Even though we
will see that carbon markets as they currently exist do not meet the first condition, we
nonetheless ask whether a revised carbon market that met condition No.1 would also meet
condition No.2, etc. We thus build a set of increasingly hypothetical carbon markets, in which
the limitations of the current design are progressively lifted. Yet we will see that in all
cases--even with the most inclusive design--a two-tier strategy is economically justified and
necessary.
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67. Before we proceed, it is important to note that the carbon market (and hence the resulting
price of carbon) is different from other markets. The carbon market attempts to perform a
regulatory function by dealing with an externality via a market price rather than a tax. As
such, it is a proxy market for an artificial commodity. The prices generated are not only a
function of supply and demand in the carbon market, but also a function of policy decisions
on the parameters defining the commodity and the market--which carbon emissions to
include or not, for which periods, etc. Thus, the institutional design of the carbon market
becomes central to the analysis.
68. Returning to our four conditions, we first ask whether carbon markets (as currently
designed) can accommodate the `direct' long term emissions consequences of long-lived
investments.
69. In the current Kyoto agreement, an artificial time limit is created by the first
commitment period. As a result, carbon markets (including the CDM) price "avoided
carbon emissions" until 2012 only. There is no regulation constraining carbon beyond this
point (and in fact, several countries have adopted non-binding mid-century targets). However,
the `futures' market for carbon emissions is not deep (i.e., there are few buyers for emission
reductions beyond this point). Consequently, projects that save large quantities of carbon (or
carbon equivalent) until 2012 are favored by the market over projects that save small
quantities of carbon until 2012, regardless of what happens beyond 2012 (see Annex 1). This
skews investment decisions towards those that generate emission reductions before that
limit, i.e., towards emission reduction projects related to short-lived rather than long-lived
investments.
70. One could argue that this artificial time limit / constraint is irrelevant in practice because
investors in long-lived capital (say, utilities) anticipate that there will be a carbon constraint in
the future, and thus choose their equipment accordingly. Such an argument, however,
understates the relevance of the constraint. In fact, a given population of investors will have a
wide range of expectations about future climate policies. Some will expect that the regulation
will become tighter in the future, and will build this expectation into their investment
decisions; while others will assume that the regulatory constraint will be relaxed, delayed, or
will disappear (e.g., investors optimistic about future technology solutions to climate change).
The observed price in the carbon market may thus be higher than what it would have been
with just the deadline of 2012, because some investors may expect more stringent policies in
the future, but lower than it would have been had there been a full regulatory framework in
place for the period beyond 2012. There are also voluntary approaches to mitigation, some
going beyond 2012, but since reducing global climate change is a global public good, this
public good is likely to be undersupplied by voluntary actions alone (the standard "free rider"
problem in collective action).
71. A related issue is that many countries are not subject to emissions targets under the Kyoto
Protocol. It is true that the CDM (i.e., certified emission reductions) provides some incentive
for mitigation in non-Annex B countries. However, the demand for CDM credits (by Annex
B countries to meet their Kyoto targets) remains small relative to the number of potential
mitigation projects. In addition, these credits are subject to the same 2012 time limit. Finally,
because it is a project-based mechanism with high transaction costs, the CDM is ill-equipped
to deal with investments in large-scale programs or networks. Consequently, despite the
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CDM, most long-lived investments in non-Annex B countries do not face any form of
constraint on carbon.
72. Even in Annex B countries there are, in fact, two different types of constraints. At the
national level, all GHG-emitting sectors are accounted for in the Kyoto emissions cap. But
the national constraint is not passed on the same way to all sectors. Some sectors, such as
energy and industry, are typically included within domestic (or regional, in the case of the EU
Emissions Trading Scheme) carbon markets. As a result, individual actors within those
sectors (i.e., firms and, in some cases, households) receive emissions allowances that they can
trade on a market, thus being directly confronted by a market price for their GHG emissions.
But other sectors such as transport or construction are typically excluded from carbon
markets. They are dealt with through other types of policies and measures, such as, inter alia,
taxes, incentives, standards, etc. (For example, it would be very costly to give tradable
emissions allowances to individual households for gasoline use, while it is relatively cheap to
tax gasoline.) As a result, long-lived investments in these sectors face different incentives
from long-lived investments in sectors covered by domestic carbon markets, with a different
price (or a shadow price) of carbon.47
73. Ultimately, one has to advocate longer-term emission reduction commitment periods for
those countries that already have commitments, and a broadening of the countries and sectors
subject to mandatory restrictions where carbon markets are not currently operative. This
problem seems to be recognized by the current negotiations for a post-Kyoto framework,
which are likely to expand countries and sectors subject to carbon regulations. However, they
are still likely to institute a new commitment period rather than an unlimited one. To that
extent, the bias in transactions/projects against emissions streams associated with long-lived
capital is likely to persist, but for a different time period. If the new commitment period is
substantially less than 30 years, this would continue to create problems for infrastructure
projects, in so far as typical cost-benefit calculation for energy or infrastructure projects go
up to 30 years in the future. They generally do not go longer because of (i) the increasing
uncertainty surrounding all parameters as the horizon is extended; (ii) the discount rate, which
erodes the value of future streams of costs/benefits; and (iii) institutional limitations
(difficulties in establishing contracts or making commitments for the very long run). Thus, a
30-year commitment period for carbon markets would probably be sufficient to provide a
signal to project developers (private and public). But this would still not be sufficient for
network developers. For the latter, an even longer period may be required (but may not be
practical yet). Until more activities are subject to carbon constraints, and carbon is
priced for longer periods, `targeted mitigation programs' to reduce emission streams
associated with long-lived capital are justified. In this case, `targeted mitigation programs'
may take the form of instruments that support low-carbon long-lived investments, such as
public purchase of emission allowances beyond the carbon market horizon.
74. Second, we ask whether carbon markets can accommodate (in principle) the `indirect'
and `induced' emissions consequences of investments in long-lived systems
47
This difference arises because in practice there is no reason why the shadow price of carbon that derives from the
domestic policies and measures imposed on the sectors not covered by domestic carbon markets should equal the
price of carbon on formal carbon markets--even though this would be the most desirable outcome from a national
welfare perspective.
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75. As noted in section 1, investments in most categories of long-lived capital stock differ
from other types of mitigation investments in that they can generate externalities that
induce more investments in similar technology in the future, restrict the ability to shift to less
carbon intensive options, and thus influence mitigation costs down the road. The
intertemporal externality or positive feedback mechanisms involved have been enumerated
before (cf. paragraph 8). They include inter alia economies of scale for technology producers
or for upstream/downstream operations (e.g., in the fuel supply chain for fossil-fuel power
plants) that reduce unit costs, learning by doing effects along the chain, or agglomeration
economies. In addition, high switching costs may make it even more difficult to shift away
from one technology once it has been adopted, thereby reinforcing the lock-in effect.
76. These externalities are particularly important in the first phase of investment programs,48
because the choice of technology in the initial projects can lock-in the commitment to
that particular technology for the whole program. This has important implications for the
way the first projects in a program should be evaluated.
o If the initial projects are evaluated on a stand-alone basis, and not as part of a
program, the resulting decision might be erroneous. Suppose for example that the
initial project of alternative A emits less carbon than the initial project of alternative
B, but that program A emits more carbon than program B. Then, a cost-benefit
analysis based only on the emissions of the initial projects of A and B--even with the
`right' price for carbon--would underestimate the merits of the superior alternative B
(in terms of carbon emissions). In this case, the pricing of carbon is insufficient to
provide the right incentives 49--even though a carbon cap, in principle, applies to all
emissions (direct, indirect and induced).
o If, on the other hand, the initial projects are evaluated within the context of the
complete program, then in principle the problem identified above should not hold
­ though in practice it may still be a problem for lack of knowledge, methodology or
data re: indirect and induced effects. There are examples of such projects that are
conceived and executed as part of an integrated program from the start, such as in the
case of the U.S. Interstate Highway System, the Chinese highway system, or the
French nuclear program.
77. In addition, a program or network can in turn induce the development of a host of new
extensions or end uses that are not formally part of the original program or network.
The induced emissions can be private (and the result of decentralized decision-making), even
though the original program is public (and the result of centralized decision-making).
Examples include, inter alia:
Increase in the demand for goods or services induced by the development of the program
or network, but not included in the estimates conducted when the program or network is
48
Here a `program' can either be the aggregation of a multitude of similar projects (e.g., the construction of multiple
nuclear power plants in France) or the construction of a full network (e.g., the U.S. Interstate Highway), etc.
49
The decision is suboptimal from society's point of view because the decision-maker does not take into account the
fact that his or her decision locks in other decisions (and thus other emissions) down the road. This is the case when
there are multiple decision-makers (e.g., when several utilities compete in the power generation system), or when
there is one decision-maker who reasons on a project-by-project basis only.
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being developed (and thus not included in the original estimates of the potential `range' of
expected emissions associated with the implementation of the program or network).
`Indirect' creation of additional long-lived capital stock to complete and extend the
backbone network, leading to additional emissions. One example is the construction of
arterial roads by individual States to feed into an Interstate Highway system (and not part
of the original design); and the additional transportation demand they generate.50
Modifications in the development of other long-lived capital stock made possible by the
development of the network. For example, the change in land use associated with
suburbanization in the U.S. was made possible, in part, by the Interstate Highway System.
In turn, suburbanization generated increased commuting times, increased demand for
transportation, and thus higher transport-related emissions (this was compounded by the
decline in the share of traffic on public transit systems in U.S. cities because, in part, low
density suburbanization made them less cost-effective)--these induced effects of
suburbanization related to the transport sector are separate from the energy demand for
e.g., heating and cooling, generated by lower density development associated with
suburbanization.
Indirect macroeconomic effects on economic growth that generate emissions. For
example, it is estimated that by making trade easier, the U.S. Interstate Highway System
has contributed to an increase in economic growth relative to what it would have been in
the absence of the System (Cox and Love, 1996). As a result, total U.S. GHG emissions
are likely to have been higher with the Interstate Highway System than they would have
been in its absence.51
78. Induced emissions are external to the program and difficult to predict. But induced emissions
cannot be ignored because they would not have been possible without the core program. The
historical examples provided in section 1 suggest that indirect and induced emissions
can be significant, but empirical measures are scarce. Laird et al. (2005) review empirical
evidence of the combined network + induced effects on total economic benefits of
transportation projects in Europe. They show that taking these externalities into account can
effect total benefits positively or negatively (the latter, for example, when congestion effects
are significant). The modeling studies they cite find in fact an increase in benefits on the order
of +10% to 30% in most cases. They do not, however, provide figures on the resulting
additional emissions. Indirect and induced effects might be very difficult to estimate when a
new network is initially established (e.g., in the case of the U.S. Highway System, which was
only the second of its kind in the World after the German highway system pre-World War II).
But patterns emerging from the first example need to be taken into account when subsequent
similar networks are established (e.g., a new highway system in China). This underlines the
importance of backcasting studies using ex post data, and the learning from and sharing of
experience from other countries or regions.
50
The observed increase in annual rate of growth of VMTs after the Interstate Highway System was built was the
result of the combination of the two effects discussed previously (increased demand for transportation on the
network + creation of complements to the network).
51
This is a positive, and not a normative statement. We do not evaluate here whether or not the welfare gains
associated with higher GDP in the U.S. have been greater than the value of the externality created by the higher
GHG emissions.
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79. How should one deal with network and induced effects? As long as the cap on emissions
has both a sufficiently long time horizon and a sufficiently large sectoral and regional
coverage, then all future direct, indirect and induced emissions caused by a given program or
network will also fall under the cap.
o If the program or network is financed by the public sector, indirect and induced
emissions can in principle be accounted for in the public sector's financial
analysis. However, indirect or induced emissions that occur in foreign countries
would not be accounted for by the public sector.52
o If, on the other hand, the program or network is financed by a private entity, the
indirect or the induced emissions might occur beyond the purview of the private
entity's boundaries, and thus not be material for the entity's financial analysis of the
project. In this case, some form of policy intervention is required to make sure
that the public costs attached to the indirect and the induced emissions of the
project are internalized.
80. If indirect or induced emissions are underestimated, decisions to invest (whether from private
or public agents) may be regretted ex post (a type 3 error in the typology of Liebowitz and
Margolis). As a result--if, again, the cap on emissions has both a sufficiently long time
horizon and a sufficiently large sectoral and regional coverage--the issue is to make sure
that indirect and induced effects are taken into account, and estimated appropriately ex
ante.53 For example, carbon accounting rules for projects could be set up so that indirect and
induced effects are taken into account, via some. "standard factors". There is, however, a
need to improve methodologies for estimating these "standard factors" of indirect and
induced effects based on past patterns of similar project in similar contexts (rather than
making exact predictions for a given project in a specific context).
81. Third, we ask whether carbon markets can provide sufficient additional financing for
lumpy investments.
82. Long-lived infrastructure investments often require larger capital outlays upfront,54 and
have lower financial returns due to the inability of the private sector to mobilize resources
on the scale required by these investments, and, more fundamentally, to the inability of the
private sector to restrict access and capture the returns from the project benefits that are in
part public and extend over a longer period of time. This is a classical problem in project
financing, and it provides a rationale for public intervention in infrastructure project
financing--since private capital is not available for long enough periods at reasonable costs
(the private sector generally requires much higher returns than generated by the project to
52
Taking into account the emissions implications of public programs or networks also requires coordination among
public agencies. This is because the agency responsible for the budgetary line related to the Kyoto (or post-Kyoto
account), typically the Ministry of Finance, is likely to be different from the agency responsible for the financial
analysis of long-lived programs or networks (e.g., Ministry of Interior or Energy).
53
There is a need to improve methodologies for estimating indirect and induced effects based on past patterns of
project and context types (rather than making exact predictions of a given project).
54
Altering the design of such long-lived investments, and therefore of the associated stream of carbon, will be costly
since the costs of many of these networks are extremely large.
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justify the higher risk premiums associated with keeping capital locked up in a particular
investment for very long periods.) 55
83. For the subset of long-lived capital stock that is provided by private public partnerships or by
private participation in infrastructure, or financed through corporate finance rather than
project finance, for example in the case of utilities, the availability of a price of carbon
beyond 2012 should increase the flow of private capital to low-carbon long-lived capital stock
because in those cases private investors are able to privately capture some of the rent
generated by the carbon assets.56 However, carbon revenues (or lower carbon-related costs)
occur in the future, as the project unfolds. Thus, the fact that the differential in carbon
revenues between low-emitting and high-emitting long-lived capital stock projects can be
accounted for in the financial analysis of the project does not alleviate the need for project
financing to transform long-term revenues into upfront capital.57 Because of the longer
horizon and larger upfront costs, comparable network financing will be required to
complement carbon finance in the case of networks. Early experience with carbon finance
suggests that it is not easy to get financial institutions to enter this market and provide loans
using carbon purchase agreements as collaterals (Lecocq and Ambrosi, 2007). This situation
is likely to persist so long as low-carbon alternatives are deemed to be riskier because of a
lack of a track record relative to traditional projects with established parameters58.
84. For the (majority of) investments cases in which long-lived capital stock remains publicly
provided, we have seen above that direct, indirect and induced emissions should have a
material implication for the financial cost-benefit analysis (see paragraph 79). However,
publicly-provided programs or networks suffer from the same disconnect between the time at
which capital is needed (upfront) and the time at which carbon revenues materialize (over the
project lifetime). Project or network finance is thus also needed in the case of publicly-
provided long-lived capital stock. However, they may not necessarily tip the balance
towards low-carbon options in public infrastructure if strategic, social, and other non-
economic considerations, outweigh changes in economic returns determined by cost-benefit
analysis. As a result, it is with public projects that the price signal and financing resulting
from the carbon market is likely to have the weakest effect, even though it would still be
relevant.
85. In addition, for both privately and publicly provided long-lived capital stock projects or
networks, project or network finance requires some degree of certainty over the price of
carbon in the medium and long-run--regardless of the volatility of the price of carbon in the
short run. Whether carbon markets, even if extended over time, would provide such a signal
is in fact an open question (see paragraph 97). A lot will depend on the ability of parties to
55
Clearly there have been many cases historically of large infrastructure networks being provided by the private
sector, and more recently there has been an expansion of private participation in infrastructure provision (public-
private partnerships or PPPs and private participations in infrastructure or PPI). But the scale of what has been built
via those arrangements is still dwarfed by the size of publicly provided infrastructure.
56
To the extent, of course, that the national-level constraint on emissions has been correctly passed on to them via
regional or domestic markets (see paragraph 72).
57
Carbon revenues may not only increase the project or network's financial rate of return, but might also, with
proper financial engineering, improve its ability to obtain upfront financing (Lecocq and Ambrosi, 2007).
58
This problem might be compounded by the even more cautious lending by private financial institutions in the
future to avoid a repeat of the current economic crisis.
30/39
commit credibly to some tightening of the constraint on carbon emissions over time (e.g.,
announcing ex ante that a carbon tax will increase over time at a fixed rate).
86. Fourth, even assuming that the pricing of carbon is correct and that the additional financing
for low-carbon lumpy investments can be arranged for, we ask whether we can be sure that
investments in low-carbon technologies will be competing on a level playing field with
investments in high-carbon technologies.
87. All projects, regardless of their size, face barriers that make their implementation
difficult or even impossible despite positive net present value. Examples include inter alia
policy/regulatory barriers (e.g., landlords not having incentives to provide efficient insulation
when tenants pay the energy bills), financial barriers (e.g., lack of access to international
capital), institutional barriers (e.g., structure of governance that provide more weight to
certain interest groups in the final decision), capacity barriers (e.g., lack of skilled workforce
to operate new equipment), international/diplomatic barriers (e.g., lack of international
cooperation with neighboring countries making investments that potentially pass the cost-
benefit test difficult to implement),59 etc. A subset of barriers that are important for our
purpose are externalities (other than carbon) that are not priced (e.g., the local pollution
from coal-fired power plants when they are not priced correctly).
88. Some barriers are more likely to emerge in the case of long-lived capital stock projects,
for two main reasons. The first set of barriers that projects involving long-lived capital stock
face relate to their size and duration, thus requiring the (i) larger resources and (ii) the
coordination of a broader range of individuals and institutions, over an extended period of
time. The second set of barriers relate to the fact that long-lived capital stock projects often
produce club goods or public goods, the benefits of which cannot be easily captured.60 For
example, devising urban transport strategies that do not rely solely on the extension of one
mode of transport (e.g roads) requires institutions that are able to balance competing interests
for mobility vs. accessibility between modes / users with different needs and incomes--
particularly those of poor people (World Bank, 2002). As a result, resolving burden-sharing
and distributional and transfer issues become more difficult with long-lived capital stock
projects.61
89. Even if other barriers exist and are important, why worry about them as long as carbon is
priced correctly? If barriers are different in the high-emissions alternatives and in the low-
emissions alternatives, then the choice is biased--resulting in either over-investment in the
low-emissions alternatives (if barriers are higher for the high-emissions alternatives) or
under-investment in the low-emissions alternatives (if barriers are higher for the low-
59
For example, gas-fired power generation in India and China is very much dependent on their ability to credibly
secure supply from neighboring countries, and, in the case of India, of credibly transferring the resource across
neighboring countries.
60
The balance along the public-private dimension varies by type of long-lived investments. The benefits of telecom
networks or of individual power plants are easier to capture privately. But the benefits of power transmission lines or
of transportation networks are less easily captured by the private sector (World Bank, 1994)--though the most cost-
effective links can be privatized, i.e., "creaming".
61
Note that the use of carbon finance itself may face barriers, as carbon finance is a new financial instrument which
requires skills to be used. Otherwise, carbon may be treated only as a risk, and emissions allowances may be
inefficiently used by their holders. The global knowledge and expertise about carbon finance has yet to be
established. (In fact, it appears that newly established carbon desks in financial institutions have been disbanded with
the economic crisis.)
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emissions alternatives). Thus, if barriers are not addressed, major biases in investments in
long-lived capital stock may occur. In particular, under-investment in low-emissions
alternatives may lead to high emissions now and in the future (due to lock-ins). 62
90. What can be done in practice, then? Recognizing the presence of barriers (possibly including
non-carbon externalities) and recognizing the necessity to still act (i.e., implement low-
emissions options) requires that the barrier(s) be tackled directly. This can be done via
barrier removal, and via internalization of the non-carbon externalities. The design of these
targeted mitigation programs will depend on the nature of the barrier and/or non-carbon
externality to be removed. This suggests that the "targeted mitigation programs" that are the
focus of our paper are incorrectly named. In fact, they should not be targeted at mitigation
per se, but at other project/network development issues that constitute the barriers (e.g.,
capacity building, etc.) and /or at the non-carbon externalities (e.g., local pollution). In other
words, we are facing complex, multi-externality, multi-barriers problems that cannot be
tackled by pricing just one of these externalities--hence the need for complementary
`targeted mitigation programs'.
Conclusion
91. At present there are two approaches to mitigation, `carbon markets' and `targeted mitigation
programs'. We ask whether there is any clear economic rational for this two-tier structure.
Drawing on an analysis of the characteristics of investment in long-lived capital stock
(lumpiness, network effects) and on real-world project financing realities (notably,
observation of the role of market prices in public sector infrastructure decisions, as opposed
to shadow prices), we identify the limitations of a carbon market only approach and from that
determine the need for a combination of carbon market plus targeted mitigation policies.
92. In Section 1, we show through examples that there are categories of long-lived capital stock
that have limited turnover in a century-long period. The bulk of the capacity of networks of
long-lived capital stock (and not just individual projects) is installed in a relatively short
period of time (lumpy investments). In addition, because of externalities such as economies of
scale, learning by doing or agglomeration economies, the choice of technology in the first
projects of programs or networks can lock-in the technology over the whole program or
network. Similarly, investments in programs or networks of long-lived capital stock can
induce the development of a host of new extensions or end uses that are not formally part of
the original program or network. This has the following consequences. First, it locks-in the
future flow of emissions over the long run (or at the very least, it increases the probability that
this flow of emissions is realized). Second, failure to build-in a change in the trajectory of
these networks early will require greater and earlier efforts on other components of the capital
stock--which may not be sufficient to meet the more stringent mitigation targets, should they
become necessary.
93. In Section 2, we provide examples to illustrate that under pressures of urbanization and
globalization similar long-lived networks are being built right now in large rapidly growing
developing countries and have the potential for locking-in emissions paths for a very long
62
It is important to recall here that emissions related to long-lived capital stock are a significant part of total
emissions (see paragraphs 6 and 12), and it may become very costly to just leave out long-lived capital stock from
the global mitigation effort.
32/39
time (a century or more). We also observe that emissions paths associated with demand-side
lock-ins are not as long-lived as their associated capital stock ­ this is unlike the long lived
emissions path associated with energy supplying capital stock. However, until clean
technologies can be scaled up to replace supply-side lock-ins, actions on the demand-side are
necessary to constrain demand for energy in the interim.
94. In section 3, we show that current carbon markets do not provide adequate incentives to low-
emissions investments in long-lived capital stock, as the cap on emissions extends only to
2012, and as many countries are excluded from the system. As a result, targeted mitigation
programs in regions and sectors in which long-lived capital stock is being built at rapid rate is
necessary to complement carbon markets and avoid getting locked into highly carbon
intensive capital stock.
95. We also show that even if the constraint on emissions were extended over time, sectors and
regions, a balanced approach combining carbon markets and `targeted mitigation programs'
(direct policy intervention towards mitigation) that involve long-lived capital stock would
remain warranted. First, policy intervention is required to ensure that the emissions
externalities (indirect and induced) attached to publicly and privately produced long-lived
capital stock are taken into account and priced, above and beyond the direct emissions of the
project. Second, project and network financing may be required to bridge upfront capital
needs and effective emission reductions. Third, policy intervention may be required for both
privately and publicly provided long-lived capital stock to fix non-market barriers and non-
carbon externalities that prevent investments in long-lived low-emissions capital stock from
competing on a level playing field with high emissions alternatives, even if the former pass
the cost-efficiency test when the price of carbon is taken into account.
96. The conclusions above raise three questions. First, can indirect and induced emissions
related to a particular project be estimated ex ante? To our knowledge, no comprehensive
model exists that consistently predicts indirect and/or induced effects (or even part of induced
effects, e.g., induced demand) in any sector, even in well-studied sectors such as
transportation. But some models exist that capture part of these mechanisms, for well-defined
situations (e.g., Laird et al., 2005). In addition, indirect and induced consequences are not
always completely unpredictable either. History, economic and technical analysis and
expertise may provide insights on those indirect and induced consequences. This is clearly a
topic for further analysis.
97. A distinct, but related question is the following: Can prices on the carbon market
accurately reflect the supply/demand balance if the cap is extended over a long period of
time? The assumption that even if the cap is extended over several decades, project
developers will find a carbon price (or a price path of carbon over time) that accurately
reflects overall supply / demand over the whole period is implicit in the above discussion. Yet
existing carbon markets display important price variability, translating for the most part
uncertainty and shifting expectations about supply and demand. For example, investors in a
three-year project with emissions subject to the European Emissions Trading Scheme would
have factored in a price of carbon of at least 5-10 /tCO2 in early 2005, at the onset of the
market. Six months later, they might have used a reference price of 15-20 /tCO2. Yet EU
allowances ended up with a quasi zero value, as it was progressively discovered that the
overall cap on emissions was actually above business-as-usual emissions. Though future
carbon market may be institutionally different from current ones, uncertainty about the
33/39
resulting price is a central feature of cap-and-trade systems. This question is related to the
first in that uncertainty about indirect and induced emissions makes it difficult to evaluate
future emissions, and thus future demand for emission allowances. (In addition, future
mitigation costs are uncertain because of technical change.)63 In fact, a lot of the current
debate on the carbon market revolves around putting a ceiling and a floor to the price of
carbon (the so-called safety valve, Kopp et al., 1998).64 Defining appropriate price ceilings
and floors and the evolution of the price band is also an important topic for future research.
98. Finally, how should `targeted mitigation programs' be designed? The paper underscores
the diversity of rationale for developing `targeted mitigation programs' to complement carbon
markets, and the design of these programs will be very different depending on the challenge
to be overcome. We have even noted that the name `targeted mitigation programs' might be
misleading since programs aimed at overcoming barriers that have nothing to do with climate
change may be necessary in some cases. This reinforces the need for incorporating
development objectives (through long-lived capital financing) into climate change
negotiations (Shalizi and Lecocq, 2009).
63
In fact, investors in long-lived capital stock project may collectively find themselves in a "lose-lose" situation
where either they invest in low-emissions projects on the basis of high anticipated prices and end up with low prices,
or invest in high-emissions projects on the basis of low anticipated prices, and end up with high ones.
64
The debate between implementing a carbon tax (i.e., creating known future prices but unknown reductions in
emissions quantities) vs. a cap and trade system (own reductions in emissions quantities, but unknown prices) was
resolved in favor of the latter in the Kyoto Protocol, and seems to be poised to remain the centerpiece of the post-
Kyoto arrangement.
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Annex 1. A carbon constraint extending to 2012 only may result in incorrect investment
decisions from an economic perspective: A simple analytical illustration
Let A be a "clean" project that reduces emissions by an amount xA relative to its "dirty" baseline BA until
2012, and by quantity yA after 2012. We consider the choice between the clean project and its dirty
alternative in a financial cost-benefit framework. Let NPVBA be the net present value of the dirty
baseline, NPVA- the net present value of project A without taking carbon into account, and
CA = NVPBA ­ NPVA- the abatement cost. We assume that CA > 0, i.e. that the clean project has a
lower NPV than the dirty one when carbon is not accounted for.
Under the current Kyoto rules, only carbon until 2012 is valued. Let p be the price of carbon until 2012,
and let NPVA the net present value of project A with carbon. Project A should be undertaken over the
baseline, if and only if its NPV is positive (condition 1) and if its NPV is superior to the NPV of the
baseline (condition 2).
NPVA = NPVA- + p xA > 0 (1)
NPVA ­ NPVBA = p xA ­ CA > 0 (2)
If carbon pre- and post-2012 were valued (or if the investor was conducting an economic cost-benefit
analysis), conditions (1) and (2) would transform into (3) and (4) below, where p' is the price of carbon
beyond 2012. Everything else equal, valuing carbon beyond 2012 increases the NPV of the clean project,
both in absolute terms (eq.3) and relative to the dirty alternative (eq.4).
NPVA = NPVA- + p xA + p' yA > 0 (3)
NPVA ­ NPVBA = p xA + p' yA ­ CA > 0 (4)
Now let B be a second project in a different location, that for the sake of argument only reduces emissions
beyond 2012, but by a large amount (i.e., xB = 0 and yB >> 0). Even if NPVB > 0, project B will
automatically fail condition (2) if carbon is priced until 2012 only ­ but it would be likely to meet
condition (4) if carbon were priced beyond 2012.
Note that although we have described this framework in terms of valuing emission reductions (like, for
example, in the CDM), it also applies to investment decisions where carbon emissions are taxed at level p.
In this case, p xA is the amount saved by clean project over the dirty one in tax payments.
If projects A and B are somehow mutually exclusive (for example, if buyers seek only a limited amount of
emission reductions), then pricing carbon over the first period might lead to channeling resources to the
emission reductions activities that are in fact the costlier. Let CA/xA be the `apparent price of carbon'. A
carbon buyer will select the project that has the lowest apparent price of carbon, even though this indicator
does not correctly convey the `real' costs of emissions over the project lifetime.
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